February 02, 2016

WSJ: China’s Economic Hinge Point

China sneezed and the world caught double pneumonia. So far in 2016, oil prices and global markets have taken a pounding as China’s economy slows. The Dow is down 6%, and the Shanghai Composite lost 24% in January. Plus, the yuan has plummeted to a five-year low. And now Donald Trump wants to whack Chinese exports with a 45% tariff. Is the Great Boom of China finally ending?

There’s certainly evidence to say yes: The Shanghai stock index is down 48% from its June peak. The World Bank recently cut its forecast for China GDP growth to less than 7%, the lowest since 1990. Corruption is rampant and the authoritarian instinct to shut down markets when they falter has spooked investors.

Meanwhile, the global commodity-price bloodbath—with oil at $32 a barrel—has been blamed on China’s slowdown. The recently reached Trans-Pacific Partnership trade agreement excludes China, with President Obama saying last fall that “we can’t let countries like China write the rules of the global economy.”

Ugly, for sure. But savvy investors see turbulence and search for waves they can surf to success. Look closely and it’s clear that China’s economy of 1.4 billion people is undergoing a seismic shift—from top-down infrastructure investment to a more consumer-driven economy, moving from concrete to cars, cellphones and other consumer goods enjoyed by developed economies. Over the next several years, investors would be wise to focus on Chinese consumers buying goods and especially services (insurance, car rides, vacations).

You have to go back to the Asian currency crisis of 1997-98 to understand today’s slowdown. China’s leaders knew they had to continue modernizing; even simple things like roads and sewer systems were still lacking. They had watched neighbors South Korea and Thailand and Malaysia go under and crash their currencies trying to pay back massive dollar-denominated debt used to upgrade their own infrastructure. So instead of borrowing from abroad, China’s leaders encouraged workers to emphasize saving over shopping, which helped build more housing, highways, airports and trains.

Sure enough, China’s savings rate rose from 32% of GDP in 1980 to 50% today. Investment followed a similar trend. Household consumption dropped from 70% of GDP in 1962 to 50% in 1980 to around 35% today (it is 70% in the U.S.). That’s how you self-fund a build-out.

And it worked. According to Canadian analyst Vaclav Smil, China churned out more concrete in three years (2011-14) than the U.S. did in the entire 20th century. Aging Hutong residences are disappearing, replaced by 50-story high-rise apartments—many of which stand empty. To fund all this, China is 106th globally in household consumption at $3,900 per capita, behind Swaziland but ahead of Algeria—and about 10% of the figure for the U.S.

Chinese leaders are trying desperately to steer spending in a new direction, but it isn’t easy to turn a $10 trillion economy on a dime. Yet there are ways to change course, hopefully without blowing up the global economy.

The first step is crack down on corruption, which would help slow down infrastructure spending. Make it harder to keep building four-lane highways to places no one visits. This process has already begun. Banks are being told not to continue funding dead-end projects. Since 2012, according to the China Daily, some 270,000 officials have been charged with corrupt activities—even a member of the Politburo Standing Committee, a position akin to the president’s cabinet.

Then there’s trade: China still needs to keep its job-growth engine firing on all cylinders. As construction employment stagnates, manufacturing and logistics—major strengths of the Chinese economy—must continue to grow. China may have chosen to stay out of the Trans-Pacific Partnership—largely due to the flurry of labor and environmental standards pushed by the Obama administration—but that doesn’t mean Beijing can’t ramp up trade and exports while it waits to see how the TPP pans out for others (assuming the U.S. Congress ever gets around to voting on the deal). Putting final-assembly projects in Vietnam, Malaysia and elsewhere is a good place to start.

The lack of a social safety net is a big challenge to boosting consumer spending. Most workers lack retirement or pension plans. So a good way to spur spending is to assure them that their retirement is secure. The powers that be seem to understand this: According to the Asian Insurance Review, the Chinese government “wants insurers to play a greater role by supplying corporate pensions and health insurance, establishing a catastrophe insurance system; and improving agriculture and infrastructure.”

This trend toward consumerism is already under way—China’s big cities are plastered with ads for Porsche, Gucci and Apple products. Some 600 million Chinese have smartphones. Uber and local Didi Kuaidi are battling it out to offer rides. Airbnb is booking spare rooms. WeChat, Alibaba and others are enabling mobile purchases as most cities don’t have an equivalent of a Wal-Mart or large retail stores. The trick is spreading this desire to spend instead of save to smaller cities and more remote regions where there is less wealth and old habits die hard.

Transitions are tough and often harsh, and China’s will be no exception. Government interference will surely make matters worse. China’s stock prices may fall further, as Chinese banks are filled with junk loans and the economy may be sinking into a recession. Many state-owned companies are flailing and need to be privatized. But while everyone else scours the latest news over the GDP numbers and the Shanghai stock index, look closer: On Sunday came the announcement that China’s purchasing managers index had fallen for the sixth straight month—but consumer retail sales in China were up 10.7% last year. The Chinese consumer is waking up.